Executive Compensation: What's Reasonable?

Safe passage through the minefield of deductibility

When
a corporate client seeks words of wisdom regarding tax planning,
most CPAs go through the litany of suggestions related to
acceleration of deductions and deferral of income. Yet one of the
biggest and potentially most dangerous tax issues facing
corporations is the compensation paid to the top executives and
whether the IRS will allow the company to deduct the full
compensation paid.

PUBLIC COMPANIES AND PERFORMANCE-BASED PAY

In
the publicly traded company arena, the IRS has signaled it will
follow a literal reading of the requirements for performance-based
compensation deductible under IRC § 162(m) for amounts over $1
million. Private Letter Ruling 200804004 and Revenue Ruling 2008-13
interpreted IRC § 162(m) as disallowing a deduction even if the
employee’s contract contains performance-based criteria if the
employee can also receive the compensation for employment that is
terminated without cause or for voluntary retirement. Contract
provisions that allow compensation to be paid upon the employee’s
death or disability or a change of control or ownership of the
corporation will not cause performance-based compensation to cease
to be regarded as such.

Otherwise,
if the salary is based on objective performance criteria but
ultimately could be paid via any other provision of the employment
contract, the performance criteria is superfluous and the deduction
is lost. It is irrelevant to the IRS whether in hindsight the
payments were made because the objective performance criteria were
met or whether termination without cause or a retirement led to the payment.

Let’s
assume a CEO is making $1 million per year in base pay and has
another $4 million in performance-based incentives. The incentives
can be objectively analyzed and approved and can meet the criteria
for deduction under IRC § 162(m)(4)(C). Again, as long as no part of
the incentives may be paid for any reason besides meeting the
performance measures, other than death, disability or change in
control or ownership, the total salary of $5 million can be deducted.

LOWER SALARIES NOT IMMUNE FROM SCRUTINY

Trades or
businesses must also show that their deductions for employee
compensation, even for amounts less than $1 million, are reasonable.
This issue arises most often in the context of private companies.

The
author recently litigated a Tax Court case involving the
deductibility of salary paid to a woman who was a principal owner,
the chairwoman of the board and the CEO of such a company and
appealed the finding to the Ninth Circuit Court of Appeals (E.J.
Harrison & Sons Inc. v. Commissioner, TC memos 2003-239
and 2006-133 (aff’d in part and rev’d in part, 9th
Cir., 2005 and 2008)). The Ninth Circuit affirmed the Tax Court in
part but reversed and remanded for further proceedings to determine
a more appropriate basis than the Tax Court had applied for
determining reasonable compensation, to include her role in running
the corporation.

The
facts were fairly simple and typical. At the end of the year, the
board of directors determined what the CEO’s bonuses should be and
set her compensation for the following year. It was a family- owned
and -run multimillion-dollar business. The board rewarded the CEO
for the company’s ongoing profitability with a handsome salary, but
it was less than $1 million for each year under audit. There was
very little discussion about incentives or goals being reached in
calculating her salary, certainly not in writing or reflected in any
minutes. As in most small corporations, board members were basing
their decisions on instincts and fairness.

The
board had no idea that the IRS could, in essence, look over their
shoulders and determine that their business judgment regarding her
compensation was “unreasonable” and subject to second-guessing. Most
directors of small companies may be unaware of this fact. Of course,
if the IRS can recategorize the salary as a profit distribution, the
deduction is lost and the CEO/owner is deemed to have received a
dividend distribution. The deduction must reflect “a reasonable
allowance for salaries or other compensation for personal services
actually rendered” (IRC § 162(a)(1)). It may be paid in stock or
other property or be made contingent on profits but should reflect
what would “ordinarily be paid for like services by like enterprises
under like circumstances” as they existed at the time the amount was
set (Treas. Reg. § 1.162-7(b)(3)).

The
provisions are intended to prevent corporate taxpayers from
characterizing as salary amounts that are actually dividends. But
just as determining the value of many things is often problematic,
so is fixing and documenting reasonableness of compensation.

S
corporations also face the reasonable compensation issue, but unlike
owner/employees of C corporations, owner/employees of S corporations
must make sure their salary is not unreasonably low compared with
the S corporation’s distributions to them. If it is, the IRS may
reclassify distributions as salary and assess liability and
penalties for any unpaid payroll taxes.

INDEPENDENT INVESTOR APPROACH

The
tests for what is reasonable compensation in the private company
arena are literally all over the map, and the exact test used
depends upon which federal circuit the company litigates in. In the
author’s judgment, the most reasonable, well-thought-out opinion in
this area was written by Judge Richard Posner of the Seventh Circuit
Court of Appeals in Exacto Spring Corp. v. Commissioner (196
F.3d 833 (7th Cir. 1999)). Most
other circuits use a plethora of tests, formulas and analyses that
provide a tortuous trail of “guidance” to a small corporation much
akin to a trail of breadcrumbs left for lost hikers (see sidebar,
“In
Search of a Standard”).

The
Seventh Circuit, which covers Illinois, Indiana and Wisconsin, made
the determination very simple in Exacto Spring. It relied
upon a measure of performance based on a corporation’s return on
equity (ROE). This measure is commonly referred to as the
independent investor test, since

it
views ROE from the perspective of a hypothetical independent
investor. It has been widely acknowledged as important in
determining reasonable compensation and has been used for at least
26 years by various courts, including the Tax Court. But usually,
courts consider it along with other factors that Judge Posner
criticized as vague, subjective and, in Exacto Spring,
supporting a decision contrary to the one the Tax Court, applying
them, had then made. (In March this year, the Seventh Circuit again
ruled on the same issue in Menard Inc., No. 08-2125 (7th Cir. 3/10/09)).

Again, an
opinion written by Judge Posner relied predominantly on an
independent investor test in overruling the Tax Court. This time,
the Seventh Circuit held that a $20 million bonus paid to the
founder and CEO of a privately held chain of hardware stores was
reasonable (see sidebar, “‘Workaholic’ CEO Worth $20 Million a
Year,” below).

Several
courts have applied the independent investor test to more than one
employee at a time. However, the Tax Court has criticized the use of
the test in this context because, by itself, it provides no
guidelines for how reasonable compensation might be determined among
several employees who might be considered responsible for a
satisfactory ROE.

HELPING COMPANIES APPLY THE TEST

CPAs
and other outside professionals advising the management and
directors of privately held businesses can suggest that they prepare
and review an analysis of reasonable compensation including an
independent investor test and record it as an exhibit in the minutes
of board meetings, along with their findings regarding it. The board
of directors typically will then turn back to the CPA and request
guidance on how to do the analysis.

The
analysis boils down to this: Test the different rates of ROE at
different salary levels and choose the salary level at which the
hypothetical independent investor would be satisfied with his or her
rate of return. If the company is providing a rate of return of 10%
to this hypothetical investor in today’s economic climate, wouldn’t
this hypothetical investor be happy? Ecstatic at 15%? Whatever the
resulting salary figure, it then becomes a presumptively reasonable
salary for the executive being measured. For companies in the
Seventh Circuit, this analysis may be all that is needed. Those in
other circuits may want to include analyses of other factors.
Perhaps most important, the board should make sure the study is
thoroughly documented.

When
considering a low or negative ROE, courts may take unusual or
one-time charges into consideration The company can document the
cause of the expenditure, treat one year as an aberration and use a
longer testing period (consistent with any
known or likely tax audit period). For example, in E.J.
Harrison & Sons, the taxpayer argued that a one-year
negative ROE was attributable to a mandate by the California
Legislature. Harrison was among contract waste haulers required to
implement a state recycling initiative by providing individual
customers new barrels for recyclables and yard waste in addition
to their existing household waste bin. This requirement forced the
company to make a large cash outlay in one year. A company’s board
of directors in such a situation could choose a three- or
four-year window to do an independent investor analysis, on the
theory that a change in the law artificially affected the ROE. The
key here is the discussion must be documented and the officer’s
salary justified in the context of the events.

Additional
factors companies might consider besides the independent investor
test include some measure of the CEO’s effectiveness. “The nature
and quality of the services should be considered, as well as the
effect of those services on the return the investor is seeing on his
investment,” wrote the Ninth Circuit in Elliotts Inc. v.
Commissioner (716 F.2d 1241 (1983)). The nature and quality of
the services performed by the employee is an overarching principle
in a five-factor test the Ninth Circuit adopted in Elliotts
and reaffirmed in Labelgraphics Inc. v. Commissioner (221
F.3d 1091 (2000)).

Although
the Elliotts court merely called the independent investor
test “helpful,” it remanded the case to the Tax Court to reconsider
the independent investor test as a factor, and some other courts
have accorded it a greater, if not commanding, role. Besides the
Seventh Circuit’s giving the independent investor test primacy, the
Second Circuit has stated that the five Elliotts factors
should be viewed from the perspective of the independent investor.
Other circuits that regard the test as important include the First,
Fifth and Sixth. But most courts also employ some matrix of the
other Elliotts factors, often along with still other criteria.

The
problem that privately held corporations confront with this
labyrinth of factsand- circumstances-based tests is that they are
expensive to administer in practice. What small corporation wants to
hire salary consultants to do comparisons to similarly situated
companies? The independent investor test is a good starting point
because it is factual and relatively easy to determine. It is a
calculation that CPAs can easily perform and that corporate clients
will easily understand.

CPAs
who advise or represent privately held corporations can suggest
directors do three things: One, use the performance-based
compensation provisions applicable to publicly held corporations as
a model and make sure that executives’ salaries are mostly
performance- driven. Two, apply the independent investor test before
setting the salaries. And last, document the resulting
determinations in minutes of their meetings.

“Workaholic” CEO Worth $20 Million a Year

In
March 2009, a decade after the Seventh Circuit Court of Appeals
first declared its preference for a single factor rather than a
matrix to determine reasonable employee compensation under IRC §
162(a), the court reasserted the primacy of that factor: return on
equity (ROE) to a hypothetical investor in a closely held
corporation. The opinions in both the earlier case, Exacto
Spring (196 F.3d 833 (7th Cir. 1999)), and the one this
year, Menard Inc. v. Commissioner (No. 08-2125, 7th Cir.
3/10/09) both overruled the Tax Court in favor of the taxpayers.
Both were written by the same judge, Richard A. Posner.

The
latter decision was notable chiefly for the amount of compensation
deducted, $20,642,400 for 1998, the bulk of which ($17,467,800)
was paid in the form of a bonus of 5% of the company’s before-tax
profits. The Tax Court had ruled that the arrangement for John
Menard, founder and CEO of a Midwestern chain of hardware stores,
Menard Inc., looked more like a dividend than a salary. Although
the 5% bonus had been in place since 1973, the Tax Court was
troubled by a provision in Menard’s contract requiring him to pay
back any deduction of it disallowed by the IRS. The Tax Court also
applied Treas. Reg. § 1.162-7(b)(3), which states that
compensation may be assumed reasonable where it is consistent with
the pay of similar companies under similar circumstances for
similar services. On that basis, it compared Menard’s pay with
that of CEOs for Lowe’s Cos. Inc. and The Home Depot Inc. relative
to those two public companies’ ROE and arrived at a figure for
Menard of $7.1 million.

But,
Judge Posner wrote, the Tax Court ignored dissimilarities between
Menard Inc. and its much larger rivals, notably the level of
service that Menard provided. He worked 12 to 16 hours a day, six
or seven days a week and took only seven days of vacation a year.
Under his leadership, company revenues grew in seven years from
$788 million to $3.4 billion. And most tellingly, Judge Posner
wrote, at the end of that period, the tax year in dispute, a
hypothetical investor in Menard Inc. would have enjoyed an 18.8%
ROE for the year. In contrast to the lack of any evidence
presented regarding the individual contributions of the CEOs of
the larger companies relative to those of their directors and
senior management, there was ample evidence of Menard’s nearly
single-handed “workaholic, micromanaging ways,” Judge Posner
wrote.

The
Seventh Circuit panel also said that reasonableness under the ROE
factor may be rebutted where company success results more from
external reasons than an employee’s exertions or where there is a
conflict of interest. The compensation paid other executives
within the company is considered relevant, as well.

—by
Paul Bonner

EXECUTIVE SUMMARY

For
public companies, IRC § 162(m) requires that
compensation over $1 million be conditioned on performance. In
rulings last year, the IRS said that an employment contract that
specifies performance-based criteria for the compensation will not
ensure deductibility where provisions also allow the compensation
to be paid upon events other than meeting the performance
criteria, unless for death or disability of the employee or change
of ownership or control of the company.

Trades or businesses must also show that their deductions for
employee compensation, even for amounts less than $1 million, are
reasonable. Because employee compensation is deductible but
distributions are not, the IRS can scrutinize claimed deductions
for compensation to owner/shareholders of C corporations and
recharacterize amounts as distributions. A deduction must reflect
“a reasonable allowance for salaries actually rendered” (IRC §
162(a)(1)) reflecting what would “ordinarily be paid for like
services by like enterprises under like circumstances” (Treas.
Reg. § 1.162-7(b)(3)). Courts have applied a variety of
multifactor tests.

One
factor in determining reasonable compensation that
has gained prominence in some circuits, particularly the Seventh, is
the value of the employee’s contributions as reflected in the return
on equity (ROE) of a hypothetical independent investor in the
corporation, and the effect of that compensation on ROE. These are
calculations CPAs are well-equipped to assist companies in
making.

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